After letters from at least 48 MPs, the UK Conservative party will now hold a confidence vote in its leader later today. If the incumbent UK PM May fails to secure a majority of Tory MPs, a leadership contest will be triggered. The postponement of the Parliamentary vote on May’s Withdrawal Agreement and subsequent day of flying around Europe meeting heads of state, yet appearing to achieve little but photo opportunities has forced the matter to a head. Regardless of the outcome of the confidence vote, the Brexit process is at stalemate with the UK Parliament unable to ratify the only agreement the EU is prepared to offer to date.
We believe investors must separate the ideological and political questions from the economics. The current Withdrawal Agreement would provide a significant degree of certainty for UK business during a transition period, if as we suspect it would prove more than transient given the difficulties of establishing a free trade agreement. A new free trade agreement would also have to be seen to benefit the EU and prove a strong disincentive to other nations to consider leaving the EU.
Prior to the ECJ’s recent decision that the UK could unilaterally withdraw its Article 50 notification there was a risk that the UK could have been forced out of the EU on no-deal terms in March. This cannot now happen. Investors may fear the risk of a deliberate no-deal Brexit should a new hardline Conservative administration seize power. However, the limited preparations for no-deal to date and likelihood of Parliamentary vote of no-confidence should any new administration try this route, make this an outlier scenario in our view. There appears at present little support in Parliament for a chaotic no-deal Brexit.
Our base case therefore is that a successful leadership challenge results in a government with an element of cross-party support in respect of Brexit. Potential Brexiteers would have to convince Parliament that they have a workable no-deal strategy, in which case revocation of Article 50 would appear to be necessary to provide sufficient time for detailed preparations. A soft Brexit leadership would similarly be incentivised to try to extend Article 50 in order to renegotiate a deal from the position of requiring a fix for the Irish backstop and increased clarity on future trade arrangements. It may be counter-intuitive but the need for unanimity on an extension for Article 50 means that an anti-EU UK administration might be forced to opt for stronger outright revocation and renotification later strategy.
In either of these scenarios, Brexit would not happen in March 2019. Furthermore, if there is a general election in Q1 2019, the EU would also have to accept the current Withdrawal Agreement would be dead as no new UK leader would wish to start from a point of failure. An extension to Article 50 would also be highly likely in these circumstances.
We believe therefore the Brexit process has reached a point of reset which is very likely to materially delay the exit of the UK from the EU, if it happens at all. Uncertainty will remain elevated and investment decisions will continue to be postponed unless offsetting UK policy initiatives can convince the corporate sector to maintain investment in the UK. The slowing economic momentum on both sides of the English Channel, partly as a result of Brexit, justifies in part the market underperformance of UK equities.
However, following the ECJ decision the risk of a calamitous no-deal scenario is much reduced in our view. UK equity valuations are now priced at levels which discount much of the uncertainty expected in coming quarters. The median forecast cashflow yield for the FTSE350 has risen from the 2014-2018 average of 4.5% to over 6% in recent months. With both AIM and the FTSE 250 having declined by close to 20% from the highs of earlier 2018, we believe the time to be mechanically underweight UK equities because of Brexit has passed, even if volatility is likely to persist in the short-run.